April 2000 | Volume 51, Issue 2
When the news hit early this year that America Online, founded only fifteen years ago, would buy Time Warner, a media giant whose history reaches back into the early 1920s, The New York Times devoted almost two-thirds of its front page to the story. That is not surprising. At $165 billion, it was by far the largest merger in American corporate history.
It was Henry Luce, founder of the Time half of Time Warner in 1923, who dubbed the twentieth the American Century. But if this merger is any indication, the twenty-first century might turn out to be equally American, thanks to among other things the Internet, the home turf of AOL.
The Internet bids fair to be to the new century what the railroad was to the nineteenth: the maker of a whole new economic universe. And it is largely an American enterprise. American corporations collect 85 percent of the revenues from Internet business and have 95 percent of the stock market value of Internet companies. Almost half the people regularly on-line live in the United States.
The whole culture of the Net, as it is developing, is youthful, individualistic, decentralized, and mightily unimpressed with authority. In other words, it is very American. To be sure, our economic power and its technological lead would have assured a powerful American influence on this remarkable new platform for human interaction and economic activity in any event. But a major share of the credit must go to a now-forgotten congressman. William Steiger, Republican of Wisconsin, never heard of the Internet, but he understood how powerful self-interest is in motivating human beings to take the risks necessary to innovate. That’s why he worked so hard to reform the capital gains tax.
Capital gains result when a person or corporation buys an asset and later sells it at a higher price. When the first modern income tax was passed in 1913, capital gains were treated no differently from other income, such as salary or dividends. But they are different, for while one cannot receive a negative salary or dividend, one can certainly suffer a loss on an investment. Originally, investors could simply deduct these capital losses against all income.
But when the Crash of 1929 marked the onset of the Great Depression, the wealthy often found themselves holding stock on which they had large losses. By selling that stock, establishing the loss, and then buying it back immediately, these people could avoid taxes on their regular incomes without altering their control of the corporations involved. In 1930,1931, and 1932, J. P. Morgan, Jr., the nation’s most famous and powerful banker, used this technique and paid no income taxes at all.
To correct what was viewed as a gross inequity, the Congress changed the treatment of capital gains for tax purposes. Henceforth, half of all capital gains would be excluded from taxation. But, in exchange, capital losses could be deducted only against capital gains, not regular income, except for a thousand dollars a year (much later raised to three thousand).
Capital gains have other peculiarities, besides capital losses, that set them apart from ordinary income. Salaries, wages, dividends, and interest are paid at regular intervals, and thus the person receiving them inevitably incurs a tax liability on the income. But one does not have to sell a stock or building lot. If an asset rises sharply in value, there is greater and greater reason to hang on to it rather than to realize the profit and hand over a large chunk to the government. Also, in inflationary periods much of the gain may be only the effect of the inflation but is fully taxable anyway, again making the holder reluctant to sell. This locking-in effect inhibits the free flow of capital to areas of new opportunity.
And there is one more difference between capital gains and other income. By definition, before one can have a capital gain, one must have capital, which means that capital gains taxes are paid mostly by people at middle- and upper-income levels. This makes capital gains especially susceptible to political demagogy.
In 1969 the Treasury Secretary of the outgoing Johnson administration, Joseph Barr, testified before Congress that in 1967 there had been 155 tax returns filed that showed incomes in excess of two hundred thousand dollars but no tax liabilities. There had been 21 with million-plus incomes but no income taxes. This was perceived, correctly, as unfair. The cause, of course, was the endless complexity of the tax code, including such provisions as allowing state and city bonds to be untaxed.
Although the top 5 percent of taxpayers in this country in 1969, who earned 20 percent of the income, paid 40 percent of the taxes, Congress set about pursuing the twenty-one millionaires who had accountants clever enough to help them escape taxes. It passed laws requiring the payment of minimum taxes and then alternative minimum taxes. It is doubtful that all this new complexity corralled every last escaping taxpayer, but it certainly had a terribly adverse impact on the capital gains tax.
It pushed it in many cases to nearly 50 percent. The results were quietly disastrous—quiet because the media, fixated on the twenty-one millionaires, failed to notice. In 1968, when the tax rate on capital gains had been no higher than 25 percent, the government had collected thirty-three billion dollars in capital gains taxes. In 1977, when it ranged as high as 50 percent, receipts were down to twenty-four billion, adjusted for inflation. Even worse, where there had been more than three hundred high tech start-up companies in 1968, there were none at all in 1976.
The reason was simple enough. Starting a company utilizing new technology is a very high-risk affair. And one of the iron laws of economics is that the higher the risk, the higher must be the potential reward for investors or the risk won’t be taken. But the capital gains tax now took 50 percent of the reward in the case of success, while the losses in case of failure could only be offset against possible future gains. Rep. William Steiger resolved to do something about that.
Steiger had been born in Oshkosh, Wisconsin, in 1938, and went to high school there. Blessed with a sunny disposition and no little wit, he also had a first-rate mind and graduated from the University of Wisconsin with a degree in economics. He won a seat in the Wisconsin legislature the year he graduated. In 1966 he was elected to Congress. Aged only twenty-eight, he was the youngest member of the House when he took his seat.
The Republican party by the late 1970s was in deep political disarray. Stained by the Watergate scandal, it was perceived as the party of the past, controlled by old white men set in their ways. In the 1976 election Republicans won only 158 seats in the House, leaving the Democrats a huge 112-seat majority.
Regardless, Steiger, a member of the House Ways and Means Committee, which writes tax legislation, worked to convince his colleagues to make capital gains taxes part of the Tax Reform Act of 1978. Fairness (getting those twenty-one escapees to pay their share) was still the banner under which most tax reforms were proposed at that time. President Carter wanted to eliminate deductions for the three-martini lunch and other business expenses. The Kemp-Roth proposal to reduce marginal rates across the board, an idea that would carry Ronald Reagan to the White House two years later, was still widely ridiculed.
Steiger was a persuasive man. He soon lined up his fellow Republicans on Ways and Means, and he also got seven, and later thirteen, Democrats to join him, giving him a two-to-one majority. The media and the Democratic establishment fought the proposal tooth and nail. President Carter threatened to veto the bill. The New York Times , ignoring the history of the 1930s, argued for eliminating all distinctions between income and capital gains. Sen. Edward Kennedy, nestled in the bosom of his father’s fortune and having no need to make his own, denounced the proposal as a giveaway to the rich.
But Steiger, who had proposed a top tax rate of 25 percent for capital gains, was able to get a 28 percent top rate through Congress, and Carter, despite his veto threat, signed the bill into law on November 6, 1978. The effect was immediate. In 1977 only $39 million had been raised by the venture capital industry. By 1981 it was $1.3 billion. Initial public offerings had averaged only 28 a year in the mid-seventies. They jumped to 103 in 1979, the year after the Steiger amendment, and reached 953 in 1986. The great boom of the last two decades of the twentieth century owes much of its strength to William Steiger.
Because of his success with the capital gains tax, Steiger was widely viewed as a rising star in the Republican party, one who had a limitless future. It was not to be. Although a diabetic, Steiger was a vigorous man, and after a physical on November 17, he was pronounced in good health. Then, on December 4, less than a month after his triumph with the Tax Reform Act of 1978, he died of a heart attack in his sleep, aged only forty.
Life, like taxes, sometimes just isn’t fair.